The law in your community requires shop-owners to shovel snow and ice from the pavement (footpath) in front of their shops. You failed to do that. A pedestrian slipped and fell, resulting in serious and costly injury. The pedestrian has sued you. Your lawyer says that while he will vigorously defend you in the lawsuit, you should expect to lose $25,000 to cover the injured party’s costs. A court decision, however, is not expected for at least a year. Required:Should you recognise a liability for this event at the end of the financial year? Justify your answer by reference to the definitions and recognition criteria in the Conceptual Framework.
Question
The law in your community requires shop-owners to shovel snow and ice from the pavement (footpath) in front of their shops. You failed to do that. A pedestrian slipped and fell, resulting in serious and costly injury. The pedestrian has sued you. Your lawyer says that while he will vigorously defend you in the lawsuit, you should expect to lose $25,000 to cover the injured party’s costs. A court decision, however, is not expected for at least a year. Required:Should you recognise a liability for this event at the end of the financial year? Justify your answer by reference to the definitions and recognition criteria in the Conceptual Framework.
Solution
Yes, you should recognise a liability for this event at the end of the financial year. According to the Conceptual Framework, a liability is defined as a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.
In this case, the past event is the failure to shovel snow and ice from the pavement, which resulted in a pedestrian's injury. The present obligation is the lawsuit filed by the pedestrian, and the expected outflow of resources is the $25,000 that your lawyer expects you to lose in the lawsuit.
The recognition criteria in the Conceptual Framework state that an item that meets the definition of an element should be recognised if: (a) it is probable that any future economic benefit associated with the item will flow to or from the entity; and (b) the item has a cost or value that can be measured with reliability.
In this case, it is probable that an outflow of resources (the $25,000) will occur, and the cost can be measured with reliability as it has been estimated by your lawyer. Therefore, a liability should be recognised in the financial statements at the end of the financial year.
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